LIRA CURRENCY CRISIS

What caused a country that was ranked 8th in the top 20 Developing Debtor Countries (WorldBank, International Debt Statistics, 2018), with an external debt to equity ratio of only 47.8% andtouted as one of the fastest growing G20 economies in 2017 to slip and become one the biggestvillains in the story of global growth by 2018? The Turkish currency Lira has been sinking sinceJanuary 2018 and till date, has lost almost 34% of its value against US dollars and has become theworst performing currency in 2018. The Indian rupee also plunged to an all-time low and has beentrading at around Rs. 70 per dollar.

Lead Up to the Crisis

Turkey experienced an economic boom between 2002 and 2007 where the country's economygrew at an annual rate of 7.2%, also performing relatively well throughout the global financialcrisis: after a slowdown in GDP growth to just 0.6% in 2008 and a later recession (which saw a4.6% reduction in GDP).The economy strongly rebounded, producing 8.8% growth in 2010 and 9.2% in 2011 but therisks associated with a series of unresolved issues were becoming increasingly apparent whichencompassed the country’s CAD, its over-reliance on short-term external financing, andunfinished reforms, like in the education sector.This left Turkey exposed to over-dependence on investors, especially from the West in essence,Ankara had become a hostage of its own image as an economically successful state with a stablesocio-political system. The Turkish economy has been characterized by low savings rate and hastraditionally suffered from a large current account deficit. It is caused by, among other factors,a high level of imports, mainly from the country’s dependence on imported energy carriers (foreg., in 2012, the cost of energy imports made up 25% of the total value of imports), as well asby a high %age of imported intermediates used for the production of Turkish export goods - whichmeans that export growth means an increase in imports. The deficit is also a result of Turkey’shigh domestic consumption (a rise in industrial production increases imports), which isaccentuated by easily available consumer credit.All in all, have always been dependent on foreign inflows for filling the gap between imports andexports thereby making it extremely vulnerable to external conditions like sanctions and pressures.The external funds were used to finance massive government spending, fiscal deficits, andborrowings.

PAGE 1 How the Crisis unfolded?

Investment inflows were already declining in the time leading up to the crisis, owing to thepresident fueling political disagreements with countries that were major sources of investmentinflows such as Germany, France, and the Netherlands.The recent cause of major concern has been amplified by the Turkish President’s economic policy.For most of the countries, including the US and EU states, the central bank is independent ofgovernment’s influence and is solely responsible for what to do with interest rates, which meansthat it can keep control of inflation by raising them when necessary. While in case of Turkey, thepresident has taken control of the reins by claiming the exclusive power to appoint the bankersthat set interest rates in a way to cement his control and in his pursuit to put his son-in-law incharge of economic policy.As the crisis emerged, lenders in Turkey were hit by restructuring demands of corporations unableto serve their USD or EUR denominated debt, due to the loss of value of their earnings in Turkishlira. Even though financial institutions had been the driver of the Istanbul stock exchange for manyyears, contributing almost half its value, by April 2018 they accounted for less than one-third. ByMay-end, lenders were facing a surge in demand from companies seeking to reorganize debtrepayments.As of June 2018 Turkey imported $18.4B of goods while exporting about $13B. So they are in abalance of trade deficit of less than 1 % of GDP of $851B, which is worrying but a manageablecrisis. However, the country is running high on inflation, interest rate, and external debt. Withpersistent double-digit inflation currently at 15.85 %, the interest rate at 17.75 % and withan unemployment rate of 9.7%, is making the situation much more volatile.By the start of July, public restructuring requests by some of the country’s biggest businessesalready totaled $20B with other debtors not publicly listed or large enough to require disclosures.The Turkish banks’ asset quality, as well as their CAR, kept deteriorating throughout the crisis. Tocurb demand from businesses and consumers, banks continuously raised interest rates for businessand consumer loans and mortgage loan rates, towards 20% annually. Along with a correspondinggrowth in deposits, the gap between total deposits and total loans, which had been one of thehighest in emerging markets, began to narrow.This development, however, had also led to unfinished or unoccupied housing and commercialreal estate mushrooming the outskirts of Turkey’s major cities, as the president’s policies hadfueled the construction sector, where many of his business allies were very active, to lead pasteconomic growth.In March 2018, home sales fell 14% and mortgage sales declined 35% compared to a year earlierleading to Turkey currently has around 2 million unsold houses making up a backlog 3X the entirechunk of the average annual new housing sales. By the first half of 2018, the unsold stock of newhousing kept increasing, while increases in new home prices in Turkey were lagging consumerprice inflation by more than 10 %age points.Even though the CAD started narrowing in June, due to the worsening exchange rate for the lira,heavy portfolio capital outflows persisted and hence as a consequence of the earlier monetary

PAGE 2policy of easy money, any newfound fragile short-term macroeconomic stability is based on higherinterest rates created a recessionary effect for the Turkish economy.While Turkey’s refusal to free an American Pastor suspected in the Turkish coup attemptaggravated the US which increased the burden on Turkey by way of doubling import duties onsteel and aluminum exports from the country. Even though, Turkey retaliated by increasing importtaxes on US goods, such as automobiles by 120 %, alcohol by 140 % and tariffs on coal, cosmetics,and rice, the dominos started falling.Now, the global economy faces three key risks namely, high debt, increasing financialvulnerabilities, and protectionism. The fraught geopolitical situation is not helping either as themore the contagion spreads from Turkey to other susceptible economies, the more the investorswill take profits on their good assets to balance for their losses elsewhere ensuring that decouplingis impossible in the current state of financial markets.

Decoding the impact of Crisis in an Indian context

A possible rate hike in the US has invoked a sense of fear and left the investor community in astate of nervous anticipation with the Turkish crisis further compounding a foreign capital flightfrom all emerging markets. As an emerging economy, India is expected to face some turbulencein the short term, as the flight of foreign capital affects the rupee on similar grounds.As such, the rupee was among the hardest hit in Asia from the Turkey-led selloff in emergingassets, largely due to a wide CAD, that is already strained by higher oil prices and this fall in therupee’s value has implications for India’s external debt and, there are costs to be incurred inservicing in these debts since most of the debt was known to be on a short-term basis.Although, the Indian economy has learnt from 2013 and is far stronger than when it was a memberof the Fragile Five (“Fragile Five” economies of 2013—Brazil, Indonesia, India, and SouthAfrica) — with our CAD being much lower and our FER much higher than what they were in2013 and unlike Turkey, our external debt is low.The MSCI India equity index was down a meager 1.9% indicating that the investors haverecognized India’s strengths in comparison, the MSCI Emerging Markets index was down by 8.3%while among the former Fragile Five, MSCI Brazil was down 14.3%, South Africa down 18.6%,Indonesia down 15.5%, while MSCI Turkey had plunged by 52.3%.Factors such as the broader trend of currency movements in key emerging markets, the trend incrude oil prices, and the trajectory of the greenback (USD) strengthening against other currencieswill be the ones that drive the outlook for the rupee in the short term.A similar selloff at the time the crisis in Greece in 2009 was seen mainly on account of contagionfears across the Euro currency union, but most don’t view the Turkey situation surging into acrisis of those proportions. The US dollar is expected to strengthen further in the months aheadwith the anticipated rate hikes by the US Federal Reserve.The RBI has been assessing the mercurial trend in the rupee vis-à-vis the emerging marketcurrency pack and will take necessary steps to weaken the rupee to protect India’s exportcompetitiveness if all emerging market currencies are depreciating as per the investmentinformation and credit rating agency ICRA. This is one of the primary reasons that there has been

PAGE 3very little RBI intervention till now as it is of the opinion that there are external factors whichare affecting the rupee.

Overall Macroeconomic Analysis

Inflation  Because of falling lira, the inflation is going to rise in the economy since the Turkish economy is dependent upon foreign currency loans. This is evident from the fact that inflation in the economy has already reached 15.6%.  This will indirectly impact the entire economy as a whole. Ideally, whenever there is a rise in the inflation, the simple monetary policy followed by the Central banks is to increase the interest rates and by increasing the cost of borrowing reduce the money supply and consequently the demand in the economy. Thus inflation levels are controlled.  However, Erdogan (President of Turkey) believes in conservative principles stating that “interest rates are the mother and father of all evil” and since there Central Bank is not independent the rates are not hiked. This has also to do with the political reasons because the President wants people to be happy with more money in their hands.

Growth Recent US sanctions and tariffs imposed on steel and aluminum exports on account of detaining American Pastor and tight fiscal policies have had a huge impact on the growth of the economy and hence the country might soon face recession soon in the last quarter of the year 2018.

Trade Wars Turkey is the 9th largest exporter of steel with 12% of its exports going to the US. The trade wars have been ongoing since the Syrian crisis but were exasperated with the arrest of American pastor Andrew Brunson and hence America imposed tariffs @20% on Aluminum and @50% on Steel exports from Turkey. Turkey also retaliated by imposing tariffs on other American products. This will have a huge impact on turkey widening its CAD

IMF With President being totally against the rise in Interest rates, the best option available is to seek assistance from IMF to provide assistance and by this way increasing the money supply in the economy and foster growth by stabilizing Lira.

Current Account Deficit

PAGE 4 Robust demand for goods and services had led to an increase in current account deficit to USD 5.43 billion in April and the same has reduced to USD 1.8 billion in July because of weaker Lira and softer domestic demand. Overall the current account deficit is still estimated to be around USD 51.6 billion in the year which is one of the largest current account deficits in the world.

Forex reserves Countries forex reserves stand at USD 85 Billion which is comparatively lower than USD 181 billion in short-term debt denominated currencies other than the lira. Hence reserves might not be sufficient to prevent lira from spiraling downward when it falls.

FDI Turkey failed to attract FDI because of negative sentiments across the world which are safe means of financing CAD and had to depend upon short-term debt from foreign countries making the economy as a whole vulnerable.

Capital Flight  Fearing the slump in lira, both the foreign as well as local investors are moving their money out of the country. This leads to the problem of capital flight.  In order to ensure that the currency does not depreciate further, the government must implement capital controls wherein it disallows full-fledged capital flight.

Twin Deficit Problem

Similar to the USA, the country is facing twin deficit problem on account of huge borrowings and high government expenditure which makes it CAD unsustainable.

Quantitative Easing Adverse effects of QE have already been felt by a lot of emerging countries and Turkey is no different leading to dramatic depreciation in currency and negative impact on the economy.

Stock Market & Borrowing Cost

There has been a huge fall in the stock market by 17% and the government borrowing has also risen by 18% due to fall in lira.

Emerging Countries Emerging countries including turkey are facing acute problems since the central banks have stopped Quantitative Easing techniques and instead increased Fed rates which have resulted in capital outflows and hence fluctuations in their currency.

PAGE 5 Possible Solutions to stem the CrisisIn order to clamp down this crisis, one of the steps that are being demanded by the internationalmarkets is the hike of the interest rates (already above 17%) by the Turkish central bank, butaccording to the school of thought that President Erdogan and his economic team represent, this issomething impossible for Turkey as it will be seen as a pressure by the foreign powers andinternational market on Turkey. In any case, Turkey would have to raise its interest rate byalmost 750 points to bring the crisis under control to an extent.The other medium to eke out of this precarious situation is the announcement of an emergencypackage of financial support from the International Monetary Fund but a combination of boththese solutions together will be the most effective way out.